What is Passive Investing?

As an investor, you must have heard of several investment strategies, each promising a different return and reward ratio. Among them, passive investing stands out, especially for investors with little knowledge of the market or those who don’t have time to track it. But what does this investment mean? What are its types, limitations, and key points before choosing it? We will discuss all of that here.

What is passive investing?

Passive investing is a long-term strategy in which you invest in a diversified portfolio that mirrors a market index. Instead of actively buying or selling securities or stocks, you maintain long-term investments. This approach aims to steadily grow wealth over time without actively tracking global or domestic market cues.

Types of passive investment

Passive investing strategies can be classified into the following four types:

1. Index Funds

Index funds are designed to mirror the performance of a specific market index, such as the Nifty 50 or Sensex. When you invest in it, your money is pooled with other investors’ money and used to buy shares of all the companies listed in that index. The proportion of shares in the fund is the same as in the index itself.

When the index rises or falls, the fund value performs similarly. Another advantage is the lower expense ratio, as fund managers don’t need to pick or adjust stocks actively.

2. Buy and Hold Strategy

This approach requires you to buy stocks and remain invested long-term, regardless of market ups and downs. You won’t have to time the market or make frequent trades here. Instead, you rely on the belief that, over time, the stock price will rise.

For example, let’s say you buy shares of a hypothetical stock named XYZ. You believe the company has strong fundamentals and a decent market share. However, due to a global event, such as a war, the stock price plummets, and the returns remain negative for a few years. Instead of selling, you keep it in your portfolio with a long-term perspective.

3. Dollar Cost Averaging (DCA)

In DCA, you invest a fixed amount of money regularly, regardless of market conditions. Instead of timing the market, you spread your investments over time to reduce the impact of short-term volatility.

Here’s how it works: Say you invest ₹1,000 in an XYZ Mutual Fund scheme every month. When the market is down and the fund price is lower, your ₹1,000 buys more shares. When the market is up, and the price is higher, your ₹1,000 buys fewer shares. Over time, this averages out your cost per share.

4. Target Date Fund

It is a set-it-and-forget-it passive investment option designed for long-term goals like retirement. Suppose you pick a fund with a target year that matches when you plan to retire, say, 2050.

The fund automatically adjusts its mix of stocks, bonds, and other assets over time. Early on, it focuses on growth with more stocks. As the target date gets closer, it shifts to more conservative investments like bonds to reduce risk.

Things to consider when choosing a passive investment strategy

If you plan to go the passive route—through index funds or Exchange Traded Funds (ETFs)—here are a few key factors to remember before investing.

• When investing in index funds, check the tracking error. It shows how much the fund’s returns deviate from the index it tries to mimic. A lower tracking error means better performance in mirroring the index.

• When an index changes its constituents, your fund adjusts its holdings. This rebalancing is not cost-free and may lead to slippage, tax events, or price pressure. You should understand how often and how predictably the index rebalances.

• Some passive funds use derivatives like swaps or futures to replicate index returns instead of holding actual securities. This is called synthetic replication. While it can reduce costs, it exposes you to counterparty risk and a lack of transparency.

• If you invest in international index funds, you might lose some of your dividend income due to foreign withholding taxes. This is known as dividend leakage. It reduces your effective yield. You need to factor this in while calculating expected returns.

• Some ETFs might be liquid, but the securities they hold may not be. If the underlying assets are illiquid, it could lead to wider bid-ask spreads or pricing discrepancies. You should always check the ETF’s trading volume and the liquidity of its securities, especially during volatile markets.

• If you use smart beta ETFs, such as low volatility or quality-focused schemes, understand that their factor exposure can drift over time. Rebalancing schedules and changes in stock fundamentals may move the fund away from its intended strategy.

Limitations of passive investment

Passive investments have their downsides, too; here are some.

• As a passive investor, you miss short-term opportunities such as earnings surprises, sector rotations, or policy changes. Active investors can quickly reallocate based on such developments.

• Some indices are heavily skewed towards a few sectors, like tech in the Nifty IT index or financials in the Nifty Bank or Nifty Financial Services indices. If negative news related to that sector occurs, the lack of diversification can cause significant losses.

• Indices often add or remove stocks based on pre-set criteria with a time lag. This delay can cost you. When a strong performer is included, its price might have already surged. Likewise, you remain exposed to underperformers for too long before they are removed.

• Passive investing strategies don’t consider macroeconomic changes such as inflation spikes, interest rate hikes, or geopolitical tensions. While these events can severely affect certain sectors or assets, your passive allocation remains static.

Conclusion

Passive investing offers a simple approach to long-term wealth growth by mirroring market indices or maintaining steady investments without frequent trading. It is ideal for investors seeking simplicity and lower costs, especially with index funds and ETFs. However, it is important to weigh its limitations, like missing short-term opportunities and exposure to sector-specific risks.